UK markets saw marginal gains this week, with the FTSE 100 Index rising 0.2% to 10,830 points at the time of writing. Investor attention remained focused on the UK bond market, as a global sell-off pushed government borrowing costs to their highest levels since the financial crisis.
The 10-year gilt yield rose 0.11 percentage points to 5.21% on Tuesday, while the 30-year yield reached 5.90%, its highest level since 1998. The sharp increase in borrowing costs presents an early challenge for Prime Minister Andy Burnham’s new administration, with Chancellor, John Healey preparing his first Budget on October 28. Higher gilt yields will increase the government’s debt-servicing costs and put further pressure on the Chancellor to demonstrate fiscal discipline, particularly as the government seeks to fund commitments on social care and the cost of living.
The deterioration in the fiscal outlook has been compounded by renewed tensions in the Middle East, which pushed oil prices above $95 a barrel and European natural gas prices to their highest levels since 2023. Higher energy prices could add to inflationary pressures and further constrain the government’s room for manoeuvre.
Outgoing Chancellor, Rachel Reeves left her Spring Statement with a £24 billion buffer against the government’s main fiscal rule, which requires the current budget, excluding investment, to be in surplus by the end of the parliament. However, higher borrowing costs and inflation are estimated to have reduced this headroom to around £13 billion.
According to Rob Wood, Chief UK economist at Pantheon Macroeconomics, restoring the buffer to previous levels could require around £10 billion a year of tax increases or spending cuts, depending on market conditions and the latest forecasts from the Office for Budget Responsibility. Chancellor Healey has pledged not to increase the main rates of personal taxation, therefore the government may face difficult choices in the Budget.
Further increases in business taxation remain one potential option, although these could weigh on investment and economic growth. Meanwhile, economic activity remained subdued but positive. The S&P Global UK Services PMI was revised down slightly to 52.5 in August from an initial estimate of 52.8 but remained above July’s 52.1 and indicated the strongest expansion in the services sector for four months.
Overall, the combination of elevated gilt yields, renewed inflationary risks and limited fiscal headroom leaves the outlook for UK assets finely balanced ahead of the Budget.
Commodity markets
In the commodity markets, Brent crude futures traded around $95 per barrel on Friday and are on track for a weekly gain of around 7%, as rising tensions and renewed US-Iran hostilities heightened concerns over Middle East supply risks. US attacks this week that killed and wounded dozens, including Iranian civilians, marked the fiercest clashes between the two countries since July.
Israeli Defence Minister, Israel Katz renewed warnings that Israel would “cripple” Iran’s military and civilian infrastructure, including energy facilities. US Vice President JD Vance told reporters on Thursday that Washington does not plan to hold talks with Iran unless Tehran stops attacking commercial shipping in the Strait of Hormuz.
Oil’s advance was capped somewhat following comments made by Russian President, Vladimir Putin early on Friday morning, who said there remained a path to a deal to end the war in Ukraine, adding that both the US and China were prepared to support a peace settlement. Later in the day however, Reuters reported strikes on Kyiv’s Security Service Headquarters, undermining the comments made by the Russian president earlier in the day.
Meanwhile, Iran expanded its list of vessels that it deems non-compliant and subject to fines, confiscation or detention if they attempt to transit the strait. Iraqi ships remain among the few vessels Tehran has cleared to pass through Hormuz. Iraq increased its oil exports to around 2.34 million barrels per day in August from about 1.35 million barrels per day in July, two Iraqi energy officials said on Wednesday, with September exports also expected to increase as heavy discounts and Iranian approvals for Iraqi tankers encouraged buyers.
Gold prices traded around $4,480 an ounce on Friday, recovering slightly from last week’s late sell-off. The modest rebound came as investors scaled back expectations of a September interest-rate hike following comments from Federal Reserve Governor, Christopher Waller. Waller indicated that he would support keeping interest rates unchanged if incoming data continued to show that inflationary pressures were moderating, which provided some support to gold by reducing the prospect of tighter monetary policy.
Equity markets
US equity markets were little changed on Friday as investors awaited the closely watched August payrolls report for further clues on the health of the labour market and the outlook for monetary policy. In Thursday’s session, the Dow Jones Industrial Average rose 1.18%, the S&P 500 gained 1.06% and the Nasdaq Composite advanced 1.40%.
Expectations for US monetary policy shifted towards a hold in interest rates following comments from Federal Reserve Governor, Christopher Waller, who said that recent signs of easing inflationary pressures meant he would favour keeping interest rates at their current level if incoming data continued to show further progress. His comments followed similar remarks from New York Federal Reserve President, John Williams, suggesting that some policymakers are becoming more comfortable with the recent moderation in inflation.
Two-year Treasury yields, which are particularly sensitive to expectations for interest rates, fell 0.05 percentage points to 4.33% following Waller’s comments. Investors also reduced their expectations for a rate increase at the Federal Reserve’s September 16 meeting, with markets pricing roughly a 50% probability, down from 59% before Waller’s remarks.
Expectations for tighter monetary policy had increased following a hawkish speech by Federal Reserve Chair, Kevin Warsh at Jackson Hole last week, when he said the central bank still had “work to do” unless there was swift progress in bringing inflation under control. The latest data, however, have provided some reassurance. The Federal Reserve’s preferred PCE measure of inflation stood at 3.7% in July, although the monthly increase was weaker than expected.
Waller argued that underlying inflation appeared to be performing better than the core figures suggested. With inflation still materially above the Federal Reserve’s 2% target, the August payrolls report therefore represents an important test for markets. A weaker labour-market reading could reinforce expectations that the Fed will maintain interest rates rather than tighten policy, potentially supporting both bond and equity markets, while stronger employment data could revive concerns over persistent inflation and higher-for-longer interest rates.
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